Kaelea, Inc., has no debt outstanding and a total market value of $90,000. Earni
ID: 2690143 • Letter: K
Question
Kaelea, Inc., has no debt outstanding and a total market value of $90,000. Earnings before interest and taxes, EBIT, are projected to be $8,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 20 percent higher. If there is a recession, then EBIT will be 35 percent lower. Kaelea is considering a $34,000 debt issue with a 6 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 3,600 shares outstanding. Assume Kaelea has a tax rate of 35 percent.
Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is issued. (Do not include the dollar signs ($). Round your answers to 2 decimal places (e.g., 32.16).)
Calculate the percentage changes in EPS when the economy expands or enters a recession. (Do not include the percent signs (%). Negative amounts should be indicated by a minus sign.)
Calculate earnings per share, EPS, under each of the three economic scenarios after the recapitalization. (Do not include the dollar signs ($). Round your answers to 2 decimal places (e.g., 32.16).)
Calculate the percentage changes in EPS when the economy expands or enters a recession. (Do not include the percent signs (%). Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places (e.g., 32.16).)
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Kaelea, Inc., has no debt outstanding and a total market value of $90,000. Earnings before interest and taxes, EBIT, are projected to be $8,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 20 percent higher. If there is a recession, then EBIT will be 35 percent lower. Kaelea is considering a $34,000 debt issue with a 6 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 3,600 shares outstanding. Assume Kaelea has a tax rate of 35 percent.
Explanation / Answer
a. Calculate earning per share, EPS, under each of the three economic scenarios before any debts is issued. Also, calculate the percentage changes in EPS when the economy expands or enter a recession. Current Proposed Assets 90000 90000 Debt 0 34000 Equity 90000 56000 Debt-equity ratio 0 60.7 Share price $25 $25 Shares outstanding 3600 2240 34000/25=1360, 3600-1360=2240 Interest rate 6 6 Current Capital Structure: No Debt Recession Expected Expansion EBIT 5200 8000 9600 Interest 0 0 0 Net Income 5200 8000 9600 ROE 5.78% 8.89% 10.67% EPS $1.44 $2.22 $2.67 ROE = Net income/Total equity EPS = Net income/Shares outstanding EPS Recession = $1.44 Expected = $2.22 Expansion= $2.67 Percentage changes in EPS Recession = 35% down Expansion = 20.3% up b. Repeat part (a) assuming that Kaelea goes through with recapitalization. What do you observe? Proposed Capital Structure: Debt = $34,000 Recession Expected Expansion EBIT 5200 8000 9600 Interest 2040 2040 2040 Net Income 3160 5960 7560 ROE 5.64% 10.64% 13.50% EPS $1.41 $2.66 $3.38 EPS Recession = $1.41 Expected = $2.66 Expansion= $3.38 Percentage changes in EPS Recession = 47% down Expansion = 27.1% up
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